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News February 6 & 13, 2012 Issue

Enforcement-Related Matters

On the only panel comprised entirely of SEC staff, the discussion of enforcement related matters was lead by both co-chiefs of the specialized Asset Management Unit, Bruce Karpati and Robert Kaplan, the head of the Division of Investment Managementís Office of Enforcement Liaison Barbara Chretien-Dar, and director of the SECís Los Angeles Regional Office Rosalind Tyson.

There was no back and forth with the industry here, the message was "hereís whatís important to us, hereís what weíre seeing, and hereís where you can look for guidance for your own compliance program."

Valuation is a key area of interest.

Bruce Karpati lead off the discussion. The Asset Management Unit has about 70 staff, primarily attorneys and analysts, he said. That staff is spread across nine of the SECís nationwide offices, soon to be ten as the Unit adds staff in the Denver Regional Office.

A significant percentage of the Unitís resources are focused on valuation, said Karpati. Valuation is a key component when it comes to fees, for both private funds and mutual funds. A fundamental issue of focus in the Unit is the Valuation Committee, and whether it is following the practices it claims to follow, especially where those practices are being disclosed to others.

When policies and procedures are represented to investors, we expect thatís what is taking place, said Karpati. The Unit is always looking for reasonable safeguards to be in place around the valuation process and that it is run as represented.

The Unit focuses on side pockets, marking the close, and liquidity representations.

Unaddressed conflicts of interest often equal trouble.

The Unit also seeks to uncover undisclosed conflicts of interest, especially self-dealing by advisers, said Kaplan. The entire system should be designed to detect and manage conflicts of interest.

Kaplan said it is shocking how often the staff sees private pools taking loans from their own funds. Other common conflicts the Unit sees:

  • Investments that are obvious self-dealing, and not authorized by the fund formation documents;
  • Pooled funds investing in other funds or investment vehicles owned partially by the adviser;
  • One client account disadvantaged to the benefit of another, especially in cross transactions with side-by-side accounts; and
  • Preferential redemptions, such as when a fund adviser with skin in the game redeems itself or select others out when other investors are unable to redeem.

Other areas of importance to the Asset Management Unit.

When reviewing a firmís compliance programs and controls, it is important that programs and procedures are geared to the firmís business, said Karpati. The staff will also look for board oversight of compliance.

The Unit focuses on high-risk products and products sold through broker-dealers, said Kaplan. Particular areas of concern include certain variable products, annuities, and life settlements, and ETFs Ė especially the ultra short, leveraged ETFs Ė sold in a misleading manner or to unsuitable investors.

Lack of cooperation in an exam setting is one of the biggest issues for us, said Karpati. If the staff suspects records donít exist, added Kaplan, then what other problems might exist?

The Unit sees problems with the [Investment Company Act] Section 15(c) process. An adviser is not providing accurate information to the Board, and the board cannot appropriately exercise its obligations in evaluating the advisory contract. The staff is experienced in looking beyond board minutes to get an accurate picture of the advisory contract review process, said Karpati.


The Unit partners with the examination staff, the Division of Risk, Financial Analysis, and Strategy, and the Division of Investment Management to evaluate information and learn more, said Karpati. For example, fund performance and fee arrangements provide data that can be analyzed. Aberrational performance is a real marker for the Unit in detecting and preventing further fraud, he said. Another good marker is possibly excessive fee arrangements for both private funds and mutual funds. The Unit engages in proactive analysis there. The Morgan Stanley case is a good example of what can go wrong when thereís a lack of oversight in the review and vetting of fee arrangements.

Private equity arrangements getting a closer look.

The staff has undertaken an initiative with respect to private equity managers, said Kaplan. The Unit has been looking at valuations, and looking generally at the business and conduct of operations. Given the prominence of private equity investing, "itís in our sweet-spot of priorities," he said. The Unit is looking into things like arrangements that result in double-charging portfolio companies and illegal broken deal fees.

Issues with smaller advisers.

Smaller advisers can lack the more robust compliance program that the staff likes to see, said Kaplan. Often the compliance function is chosen randomly, given to the employee with the lightest load, for example. This is not the best way to choose the most suitable professional for this important task, said Kaplan. The Unit also has observed that offering frauds are more common in smaller entities.

ĎIím sure it goes without saying, but try not to make a fraudulent offering or run a Ponzi scheme, because we frown on that," he said.

Enforcement actions involving advisers have risen. Hereís why.

Adviser enforcement actions are up approximately 30 percent in 2011 from 2010, and there are several reasons for the increase, said Tyson. First, risk-based examinations have been productive. Second, the staff has the ability to refer cases faster. The exam staff is encouraged to consult with Enforcement when it is apparent that that is appropriate. The tips, complaints and referrals system is operational, and it adds transparency to the referral process. "It gives a good chance that a good case will be worked by someone," she said, whether in the home office or one of the regional offices.

The formal order process has dramatically changed. In each SEC office around the country there are officers empowered to issue subpoenas and formal orders of investigation without going through the Commission or senior Enforcement personnel in the home office. It can be done in a matter of hours, particularly where money is missing or is being dissipated.

What type of referrals most often end up as enforcement actions?

Number one is fraud, Ponzi schemes, and other situations where there is actual investor harm, said Tyson. Recidivist violations are often referred to Enforcement. This is where registrants have been advised of a deficiency and fail to take corrective action. Some registrants correct only the immediate issue and fail to adjust their compliance program accordingly so the same deficiency recurs. Compliance failures that are core to the business of the registrant are more likely to result in enforcement actions as well, she said.

Enforcement actions roundup Ė where to look for the lessons.

A number of recent enforcement cases have involved valuation issues, and all of them originated from the 2007-2008 liquidity crisis, said Chretien-Dar.

"Valuation has been a perennial concern of the Commission," both in private and public funds, she said. Because mutual funds redeem and sell their shares at NAV, the consequences of an incorrectly calculated NAV can be quite dire for those funds. Boards delegate a lot of functions to the adviser, and valuation is one of them.

In the recent UBS case, which involved the acquisition of mortgage-backed securities, the order is quite instructive in looking at valuation procedures. UBS had a pricing hierarchy, and a clear process for review, change or ratification of valuations. During that process, aberrant transaction prices generated an exception report that went to compliance. Compliance then deviated from its own policy, which resulted in mispricing the fundís NAV. It was not only a violation of the pricing rule, but also a violation of the compliance rule, which has an implementation component.

The Morgan Keegan action also involved valuation issues, but the firmís policies and procedures there were not as clear as in the UBS case. The valuation policies and procedures were vague and confusing and left open whether the adviser or fund accounting was responsible for certain valuations. Deficiencies in the policies and procedures left the portfolio manager with too much discretion in determining fair valuation.

In the UBS case, there was deviation from a clear policy and tolerance reports. In the Evergreen case, the valuation hierarchies were reversed. Firms must clearly state when it is permissible to switch from one hierarchy to the other, and document those changes when they occur.

Think about your process. During volatile times, who attends valuation committee sessions? The universe of participants can expand under unusual circumstances. Think about your insider trading policies here, too. The Evergreen case was essentially a valuation case, but it also included an insider trading component. Material non-public information (MNPI) was given out in response to calls from registered representatives with panicked customers. Evergreen had no controls in place for that.

In the Charles Marquardt case, a portfolio manager was present in valuation meetings who normally wouldnít have been there. It happens in large firms with multiple lines of business, and the State Street and Schwab cases offer examples of that. Both of those cases included selective disclosure elements. During the most volatile periods in the market, valuation meetings were conducted on an "all hands" basis. People who were servicing advisory groups whose interests were affected, with an obligation to their clients, all of a sudden theyíre exposed to information and if itís MNPI, they canít act on it. Firms should give consideration to walling off underlying fund personnel.

These actions should be recommended reading when a firm is designing or updating its insider trading code, said Chretien-Dar. In particular, firms should be sensitive to the multi-function officer wearing several hats, with differing responsibilities in those varying roles.

A settled administrative proceeding with Merrill Lynch involved the firmís proprietary trading desk. The message there is that non-public information needs to be protected.

In the expert network cases, the focus is on information that grows from inside, said Chretien-Dar. Information that flows inward must also be tracked and managed. The source of the information has to be taken into consideration.

In December, Enforcement released a trio of cases involving advisory compliance program failures. In each case, the adviser had compliance deficiencies and repeatedly failed to address them.

"Many of these cases should not cause CCOs to live in fear," said Tyson. The cases are designed to remind compliance officers that policies and procedures should be tailored to and evolve with your business.

In Buckingham Research, the CCO was named and censured for failure to respond to noted deficiencies that the firm had pledged to correct.

In Wunderlich Securities, the nature of the business changed, but the compliance program didnít move with it. An Ďoff the shelfí compliance program was never tailored to the firmís actual business. The message is, said Tyson, policies need to be tailored, clear, and implemented by a designated person with the appropriate abilities and expertise. And donít adopt policies that you canít or donít intend to implement, she cautioned.

Another example of a compliance program failure is the AXA Rosenberg case, said Karpati. There you had one "heavy hitter," a controlling individual who could influence the whole program. Quant funds operate generally in a secretive way to protect their formula. Firms must ensure that compliance is at least part of the process. If not, you get "siloization" Ė people operating separate and apart from the firm. We will be very alert to that on the examination and enforcement sides, he said. Compliance must have a role and a firm should have controls around the errors process at quant managers.

When should a firm escalate something to the SEC?

A critical part of the compliance process is self-reporting and remediation once detected, said Karpati. When something is significant, thatís when you should bring it to our attention.

What if the firm didnít have written procedures for a process, is the violation less severe?

No, that would itself be a compliance program violation, said Chretien-Dar. If itís a tough area and the firm has no policies or procedures to address it, "thatís a problem."

How can a person serve as CCO when thereís the potential for personal liability?

Failure to implement what youíve specifically said youíd do is a flag for the staff, said Tyson. There are core, important elements of a compliance program, and in those areas the CCO is held to a standard of having policies and procedures in place and implementing them.